July 29, 2011

Jeffrey Thomasson, 52, may pass on more than $100 million to heirs using an estate-planning strategy for avoiding gift and estate taxes.

Thomasson, who lives in Indianapolis, said he’s funding a so-called dynasty trust set up in Delaware with $8 million of equity from the expanding financial advisory business he owns, Oxford Financial Group. Putting the assets in a trust, which he figures could be worth more than $100 million by the time he dies, means the money should go to his heirs without triggering federal gift, estate or generation-skipping transfer taxes.

“Why would I want to pay estate taxes on some really, really big number 30 years from now, if the IRS is giving me this opportunity?” Thomasson said.

A dynasty trust is used to pass money on to multiple generations of descendants while paying as little in taxes as possible. The trusts have no expiration date and there are no required minimum distributions, meaning their assets may grow for an unlimited number of future generations. While the trusts can be set up in many states, Delaware offers extra breaks, including stronger protection from creditors and potential exclusion of assets in divorce proceedings.

“It’s an astoundingly powerful vehicle for generating long-term family wealth,” said Neal Howard, chief fiduciary counsel for Philadelphia-based Glenmede, which manages more than $20 billion on behalf of individuals, families, endowments and foundations.

Interest in the trusts has risen because of the higher individual lifetime gift- and estate-tax exemptions of $5 million available this year and next, which means clients can put more tax-free money into the trusts, said Carol Kroch, head of wealth and financial planning for Wilmington Trust Co., a unit of Buffalo, New York-based M&T Bank Corp.

That limit will drop in 2013 to $1 million and the top federal tax rate on gifts and estates will rise to 55 percent from 35 percent, unless Congress acts. Gifts that skip a generation, such as from a grandparent to a grandchild, follow similar rules.

Northern Trust Corp., based in Chicago, has set up several dozen Delaware dynasty trusts on behalf of clients in 2011, compared with almost none in 2010, said Daniel Lindley, president of the Northern Trust Company of Delaware, who declined to provide more specific figures.

Protection in divorce

Delaware is one of several states, along with New Jersey and Pennsylvania, that allow so-called perpetuities, or trusts that may never expire, Lindley said. It’s also an appealing state because it’s easier to modify existing trusts there, said James Bertles, managing director of New York-based Tiedemann Wealth Management, which oversees more than $6 billion on behalf of families with $20 million or more. Delaware allows trusts greater flexibility to invest in certain assets, such as hedge funds and private equity, he said.

The state also offers stronger protections from creditors and civil litigation, including divorce proceedings, said Ted Cronin, chief executive officer of Manchester Capital Management, which directs $1.9 billion and provides tax- and estate-planning services for families with $25 million or more in assets.

“In effect, it acts as a prenup,” Cronin said.

Most Delaware trusts set up by out-of-state residents don’t owe state income or capital-gains taxes on accumulations within the trust, and pay these taxes only when distributions are made, Bertles said. Some states do tax the undistributed gains and income of dynasty trusts set up by residents, including Pennsylvania and Illinois, according to Glenmede’s Howard. The trusts owe federal income and capital-gains taxes on distributed and undistributed investment gains and income.

Dynasty trusts have gained popularity since 1986 when Congress overhauled the generation-skipping transfer tax and since then several states, including Delaware, have eliminated their rules against perpetuities. In New York, by comparison, trusts may last no longer than the lifetimes of people currently alive, plus 21 years, said Bertles, who’s based in Palm Beach, Fla. Connecticut allows for the greater of 90 years or current lives plus 21 years.

Thomasson said his Carmel, Indiana-based business, which provides investment-management and financial-planning services to families with $5 million or more, has been growing at a double-digit pace in recent years. Assuming that continues, and assuming he lives until 80, his trust could provide more than $100 million for heirs by the time he dies, when the shares would be redeemed.

‘Whimsical’ minds

“With the whimsical nature of the minds we have in Washington D.C., whenever you get an opportunity to do something from a tax standpoint, you really need to consider taking advantage of it,” Thomasson said.

A dynasty trust funded with $10 million from a couple today could be worth as much as $184 million in 50 years, assuming no intergenerational transfer taxes and a 6 percent annual return, and before subtracting any federal income or capital-gains taxes paid on the trust’s investment returns. By comparison, assets not placed in a trust and taxed twice as an estate in that period could be worth $39 million at the end of 50 years, assuming a $1 million exemption and 55 percent top rate.

The Standard & Poor’s 500 Index returned 9.6 percent annually over the 50 years through December, with dividends reinvested. A $10 million investment in the index over that period could be worth about $975 million before taxes.

Clients may fund a trust with cash, stocks or other assets, said Kara Talbott, a family office services technical adviser with Oxford. Securities such as stocks and bonds are generally valued at their current market value at the time they’re placed into the trust.

Costs to set up a dynasty trust may range from about $3,000 to more than $30,000, depending on the complexity and attorney’s fees, said Adam von Poblitz, head of estate planning at New York-based Citigroup Inc.’s private bank.

While there’s no minimum for setting up a dynasty trust, clients with about $20 million or more in assets have expressed the most interest in taking advantage of the full $5 million exemption, said Joan Crain, a family wealth strategist in Fort Lauderdale, Fla., for Bank of New York Mellon Corp.

Boosting gifts

Some clients increase their gift to the trusts by using the initial contribution to take out a loan, Bertles said. An individual can gift a trust $5 million, for example, then sell the trust $50 million in assets, using the initial $5 million as a down payment. The trust would issue a promissory note to the individual for the remaining $45 million.

The notes are treated as intra-family loans and must follow U.S. Internal Revenue Service rules on repayment and interest rates. As of July, the rates were 2 percent for loans of three to nine years. Any appreciation of the purchased assets above that interest rate pass on to the trust without triggering the gift tax, Bertles said.

One client used this strategy to transfer partial ownership of the family’s growing winery business to his children, Lindley of Northern Trust said. The client funded a trust with $4 million, which it used to purchase a $40 million share of the business, he said.

The strategy is appealing for families with a closely held business because they may be able to sell a portion to the trust at a discount of as much as 40 percent, said Laura Zeigler, a Los Angeles-based senior vice president for Bessemer Trust Co., which provides investment-management and financial-planning services for families with $10 million or more in assets. That’s because the stakes might be difficult to sell on the open market.

The trusts are irrevocable, meaning the person starting the trust has minimal control over the assets once it’s set up, and generally may change the trust only by going to court or getting approval from all beneficiaries, said BNY Mellon’s Crain.

Individuals who feel hesitant to give such a large sum away permanently can choose to structure a dynasty trust as an asset- protection trust, in which case they can name themselves as beneficiaries in order to take withdrawals under certain circumstances at the trustee’s discretion, said Northern Trust’s Lindley.

“If it turns out they’re in dire need of financial resources they can turn to us and request a distribution,” Lindley said. If they never need it, the trust’s assets will pass on to heirs as planned.